The Fed’s Bubblenomics

If you Google “dot com bubble,” you will get nearly 1.2 million hits, and 3.3 million hits if you Google “tech bubble.”

A Google search of “housing bubble” will return nearly 11 million hits. (The searches were conducted on March 29, 2017). And if you search Amazon books for financial crisis 2008 you will get more than 1200 hits.

Given all the books, monographs, essays, articles, and editorials that have been written about back-to-back bubbles that occurred within two decades, one would think there would be nothing else to write about.

The purpose of this book is to present to the general public, my fellow academicians and policymakers with an brief account and review of one of the most turbulent periods in United States history without the usual jargon academics are noted for.

As the two quotes from the Federal Reserve’s website above reveal, the Fed has been given the responsibility by the Congress of the United States to essentially promote sustainable prosperity, stabilize prices and maximize employment. During the past 100 years of the Federal Reserve’s operations, the economy has grown substantially (see Figure 1 for data since 1929), but the path to higher living standards have been interrupted by depressions/ recessions, a few bouts with double-digit price inflation and occasionally widespread unemployment. Although the Congress has expected the Federal Reserve to be a wise and prescient “helmsman,” navigating the economy from becoming overheated or plunging into a recession or worse, the Fed’s track record belies its mandates.

Figure 1

The Federal Reserve’s primary tool, open market operations, the buying and selling of US government securities with money created out of thin air, is supposed to provide sufficient “liquidity” to grease the wheels of commerce so the US economy reaches its optimal output of goods and services and maximizes employment. Thus, the Federal Reserve has what every American wishes it had, an unlimited checking account.

The US Congress created the Federal Reserve in 1913 to stabilize the economy after the Panic of 1907, and was “sold” to the American people as a measure to rein in the banks for their reckless behavior and enormous power over the economy. The fact that bankers and their allies helped draft the Federal Reserve Act seems to have been downplayed by most economists and financial historians. Others have taken a less sanguine view of central banking.

Critics of the Federal Reserve have put the blame squarely on the shoulders of former Federal Reserve chairmen, Alan Greenspan and Ben Bernanke, and their colleagues at the Federal Open Market Committee (FOMC) for voting to inflate the supply of money and credit in order to “stimulate” the economy to maintain “aggregate demand.” Both Greenspan and Bernanke defended their decisions to keep interest rates low during the second half of the 1990s and the run-up to the housing bubble of the 2000s.

Although numerous observers of the Federal Reserve’s monetary policies were warning of the incipient dot com bubble of the 1990s, Greenspan and his colleagues at the Federal Reserve brushed off their warnings, even though the former Fed Chairman himself did warn of “irrational exuberance” of stock prices in a December 1996 speech. Nevertheless, after the bubble burst in 2000 and the economy entered a mild recession, the Fed did what it always has done to “combat” an economic downturn–lower interest rates to boost output and employment.

As the federal funds rate — the rate banks borrow from each other for overnight loans — fell to 1 percent in 2003 and was kept there for a year, critics assert that the Fed helped ignite a housing bubble that led to the greatest financial crisis since the Great Depression (see Figure 2). In fact, some analysts pointed out that the housing boom actually began in the 1990s and accelerated after the relatively mild 2001 recession to its bubble peak in 2006. The 30- year mortgage rate also declined precipitously, making housing more attractive for many new homebuyers. (See Figure 3) We will discuss interest rates and the housing market in chapter 1.

Figure 2

Figure 3

So why another book on financial bubbles? The goal here is to integrate several fundamental economic and financial issues such as money, prices, interest rates, financial markets, banking, entrepreneurship, economic cycles and, of course, central banking (in chapter 1) in order to review how both policymakers and economists have assessed the US economy. In other words, if policymakers maintain that a market economy is inherently unstable and they believe they have the tools to guide employment and output on the correct path, then why did the US economy experience so much financial and economic turmoil during the past two decades? And for that matter for the past 100 years since the Federal Reserve was created in 1913?

In addition, what were Federal Reserve policymakers thinking and saying as the dot com bubble and housing bubble were unfolding? Moreover, what were economists from various schools of thought writing in real time about the boom and bust of the late 1990s and of the first decade of the 21st century? We will review their major writings and speeches in chapters 2 through 7.

In chapter 2 Alan Greenspan’s speeches, testimony to Congress and other public statements during the 1990s and early 2000 will be reviewed and analyzed. Chapter 3 will focus on Ben Bernanke’s views as the housing bubble was unfolding after he became Fed chairman in January 2006. In chapter 4 the analyses and forecasts of other Fed officials such as Janet Yellin and former Dallas Fed Pres. Richard Fisher will be examined. In addition, a review of several research papers by Fed economists during the booms and busts will also be scrutinized.

Chapter 5 will highlight the views of prominent Keynesian economists while chapter 6 will focus on the analyses of well-known monetarists and supply siders. In chapter 7, the essays and other public presentations– both written and media – of economists writing in the Austrian school tradition will be scrutinized as well.

The bottom line is what lessons have been learned by policymakers, economists, financial analysts and others who are interested in understanding how the Federal Reserve conducts its policies “to promote optimal macroeconomic performance.” If the Federal Reserve’s critics are correct, that the Fed’s “groupthink” ignored the warnings of individuals during the 1990s and early 2000’s, then the public and members of Congress should call for a reassessment of the central bank’s mission and policies—and its very existence.

If Federal Reserve officials are “blameless” for the economy’s booms and busts, then how can the average American small business owner, employee, corporate executive and retiree manage their economic and financial affairs knowing that they will have to live through more painful economic cycles in the years and decades ahead? In other words, if a market economy is always susceptible to booms and busts, then how can the Federal Reserve better “manage” the U.S. economy to avoid a painful episode like the Great Recession of 2008 – 09 in the future?

But based on the evidence compiled during the research phase of this study, the Federal Reserve cannot achieve its goals. If it could, the US economy would not have had financial bubbles in the 1990s and early 2000s. That’s why the incontrovertible fact is that the Federal Reserve is a counterproductive institution, because it is the engine of inflation, creates bubbles that causes pain among a substantial percentage of the population when the bubble bursts and increases inequality by enriching the 1 percent, who realize that the Fed is their best ally in DC, because it enormously inflates the nominal value of their assets. In short, to use the contemporary vernacular, the Federal Reserve really sucks.